Canada: Bennett Jones Fall 2016 Economic Outlook - Video

Replay the Economic Outlook seminar presented
at the Bennett Jones office on November 29.

This Fall Outlook has four sections. The first section
describes the main aspects of the "new normal" of low
growth that has prevailed for advanced economies in the last six
years of economic recovery. The second section discusses key
factors that have shaped the economic performance of advanced
economies and are likely to condition growth in aggregate demand
and potential output over the next several years. With this
analysis in background, the third section briefly explains our
short term outlook for the global economy and Canada to 2018,
showing that for the advanced economy it remains well on the
low-growth path of the "new normal". Finally, a fourth
section draws implications of the "new normal" for the
conduct of economic policies in advanced economies and the strategy
businesses should follow.

Section I: The New Normal – Low Growth: 2011-2016

The world as a whole, and notably the advanced economies (AE),
have experienced subdued growth after 2010, much below the trends
experienced before the 2008 crisis (Chart 1.1). There seems to have
been a structural break, which the usually protracted effects of
debt reduction which follow a financial crisis can explain only in
part.

Chart 1.1:

Source: IMF, World Economic Outlook, October 2016
database.

This low growth for advanced economies reflects both inadequate
demand growth and a decline in potential output growth. It was
accompanied by subdued core inflation and persistently low actual
and expected interest rates.

Demand in advanced economies was held back by several factors,
whose relative importance varies from country to country. In both
Canada and the United States the lower growth in aggregate demand
over 2011-2015 relative to 1996-2007 primarily comes from household
consumption, then from government consumption and investment, and
then from nonresidential fixed business investment.

Households adjusted to the recession by sharply raising their
saving rate and subsequently keeping them at these higher levels in
order to reduce their debt and as a precaution in the face of
uncertainty (Chart 1.3).

Governments also increased their saving rate as fiscal
consolidation followed a major stimulus in 2008-2009 and resulted
in a drag on growth until 2015 (Chart 1.4).

Chart 1.4:

Source: IMF, World Economic Outlook, October 2016
database.

Inadequate demand also reflects a lower investment rate due to
several factors, including weaker growth and pessimistic outlook
regarding future demand, housing market correction in a number of
countries, and a collapse of capital spending in the oil and gas
sector starting in 2015. (Chart 1.5).

Chart 1.5:

Source: IMF, World Economic Outlook, October 2016
database.

A lower contribution of real nonresidential business fixed
investment to real GDP growth not only slowed productivity growth
but also contributed to depress gains in international trade
intensity1 as the machinery and equipment component of
investment has a particularly high import content (Chart 1.6).

Chart 1.6:

Source: IMF, World Economic Outlook, October 2016
database. Calculations by the authors.

The slowing of growth in advanced economies partly resulted from
the negative spillovers of a deceleration of growth in China since
2011, which combined with a shift away from high-import components
of final demand and production, compressed Chinese imports from the
rest of the world (Chart 1.7).2 The slowdown in China
was indigenous for the most part, reflecting rebalancing toward a
more sustainable growth model, and some tightening of fiscal policy
and credit conditions at times.

Chart 1.7:

Source: IMF, World Economic Outlook, October 2016
database.

The slowdown in and change in composition of Chinese growth, and
more generally the slowing in world growth, combined with increased
supply in response to high prices, led to a fall in commodity
prices from their 2011 peak (Chart 1.8). In real terms, commodity
prices in 2016 are at about the same levels as at mid-2000s. These
more sustainable levels result from the termination of the
commodity supercycle that lasted from 2004 to 2014 rather than from
the structural break in the growth rate of advanced economies that
started showing up in 2011.3

Chart 1.8:

Source: IMF, World Economic Outlook, October 2016
database.

Accompanying subdued growth of demand in advanced economies was
a decline in potential output growth due to adverse demographics
and lower trend labour productivity growth (Chart 1.9). Population
aging per se would have cut growth in trend aggregate
labour force participation and hours worked by 0.4-0.5 percentage
points per year over 2011-2016. Lower productivity growth, on the
other hand, would have been partly a consequence of persistent weak
growth of demand, which discouraged business investment.

Chart 1.9:

Source: OECD database. Estimate for 2015 from the authors.

The fall in trend labour productivity growth also reflected a
fall in trend multifactor productivity (MFP) growth. In the U.S.,
trend MFP growth was unusually high in 1996-2005 as business models
and logistics more fully captured the benefits of ICT and Internet
(Chart 1.10). Trend productivity growth petered out in 2006, well
before the onset of the financial crisis, and has since remained in
the doldrums.

Chart 1.10:

Source: U.S. Bureau of Labor Statistics.

Even after several years into the recovery, core inflation has
remained subdued as a result of domestic and global excess supply
and moderate growth in wage costs (Chart 1.11).

Chart 1.11:

Sources: OECD database and U.S. Bureau of Economic Analysis.
Core inflation: U.S.: PCE excluding food and energy; Germany and
U.K.: CPI excluding food and energy. 2016 figures: U.S.: average of
January to September; Germany and U.K.: average of second and third
quarters.

Slack in the labour and product markets and low core inflation
prompted monetary authorities to keep policy interest rates near
zero and, in a few important cases, to engage in a massive
expansion of their balance sheets through quantitative easing
(Chart 1.12). The lower effectiveness of monetary policy once
policy interest rates were reduced to near zero, as they were by
2009, pervasive uncertainty about future prospects, which made
households and businesses more cautious in taking advantage of low
interest rates, high household debt levels to start with, and in
some cases credit constraints help explain why demand has remained
inadequate and inflation low in spite of exceptionally
accommodative monetary policies.

Chart 1.12:

Source: IMF, International Financial Statistics.

Financial investors' focus on the risk of prolonged
lower-than-expected inflation in a context of low growth has
contributed to expectations of low short-term rates for a long time
and hence persistently low long-term interest rates and a
flattening of the yield curve since early 2011 (Chart 1.13).

Chart 1.13:

Source: Board of Governors of the Federal Reserve System.

Summary 2011-2016

To conclude this section, it is clear that structural
developments have been less favorable to growth in the advanced
economies in the last six years than in the decade that preceded
the financial crisis. These structural developments, whose
intensity varies from country to country, relate to lower trend
productivity growth (Chart 1.9), higher saving rates by households
(Chart 1.3) and governments (Chart 1.4), lower business investment
rates (Chart 1.5), and lower trade intensity (Chart 1.6). In
addition, as will be discussed below, demographics have become more
unfavorable to growth (Chart 2.1).

Section II: Factors Conditioning Growth:
2016-2020+

The persistently low growth of advanced economies over
2011-2016 represents a structural break from the much higher trend
growth rate that prevailed during the two decades that preceded the
financial crisis. Part of this recent weak performance has been the
consequence of the financial crisis (e.g., private and public debt
reduction), the effect of which should diminish over time, and part
has been due to structural developments and increased uncertainty,
both of which likely to persist in the years to come. We believe
that these structural factors will keep demand growth by households
and businesses subdued as they realize that growth in lifetime
income and potential output would now be lower, or at least more
uncertain, than perceived before. We conclude that the "new
normal" described in Section I is likely to persist in
significant measure to at least the end of this decade and that
businesses should plan accordingly.

In this section we discuss key factors that have shaped recent
performance and are likely to condition growth in aggregate demand
and potential output over the next several years: demographics;
investment rate; productivity growth; transition in China;
commodity prices; and trade developments. The effectiveness of
economic policies in supporting growth is another such factor, but
it will be discussed in Section IV on the implications of the
"new normal" for governments and businesses.

Demographics

Various demographic projections concur in showing slower growth
in new labour force entrants and population aging (Chart 2.1) over
the next decades. These adverse trends are likely to be only partly
offset by a rise in the labour force participation of older workers
in response to economic pressures or incentives to work more and
longer, such as expected increased longevity, modest returns on
savings and improved health status. In Canada, for example,
population aging would cut labour force growth by about 0.5
percentage points per year although an increase in the labour force
participation rate of older age groups is likely to offset some of
this decline by as much as 0.2 percentage points annually in the
next several years.

The slowdown in trend hours worked resulting from demographics
will depress potential output growth and leaves less room for
demand expansion without triggering a rise in inflation. Thus
projected slower growth in potential output, partly due to
demographics, anchors projected slower growth in aggregate demand
in the medium term.

Chart 2.1:

Source: United Nations, World Population Prospects, the
2015 Revision.

Demographics, notably expected increased longevity, may also
have a direct restraining impact on household demand by prompting
workers and retirees to save more out of their current income in
order to finance a longer period of retirement (dynamic effect). It
is true that the rise in old-age dependency rates associated with
population aging may tend to reduce the aggregate household saving
rate because the increasing fraction of the population in
retirement would tend to save at a lower than average rate (static
effect). However our own calculations, based on plausible
assumptions about saving rates by age group4 and
projections of population shares by age group, show that the static
effect for Canada would be very small over the next decade and is
likely to be more than offset by a modest increase in the saving
rate of the 50-65 age group.5 On net, therefore, we
judge that demographics will likely boost the aggregate household
saving rate in Canada over the next decade and thereby directly
contribute to hold back the pace of aggregate demand growth.

Other structural factors that would have restrained household
demand growth over the last decades and might continue to do so, in
the U.S. at least, include a decline in the labour share of
national income and rising inequality of income (Chart 2.2). A
decline in the labour (compensation) share, the counterpart of
which is a rise in the capital (profits, financial investment
income, property income...) share, would tend to restrain the
contribution of consumption to real GDP growth. Rising inequality
of income would have a similar effect as an increasing share of
total income would accrue to high-saver households, thereby
reducing aggregate consumption growth.6

The consumption share of U.S. GDP actually turned out to be
higher over 2008-2015 than 1996-2007 in spite of a declining labour
share and rising inequality. This was made possible by a sharp rise
in household debt relative to income, supported by exceptionally
low interest rates and hence debt service costs. Going forward, as
interest rates rise, the room for increased reliance on debt is
limited, thereby offering little further cushion against the
negative effects on consumption of continued decline in the labour
share and rise in inequality.

Chart 2.2:

Source: U.S. Bureau of Economic Analysis.

Business Investment Rate

Business investment rates in 2011-2015 appear to have been held
back by uncertainty about growth prospects and future rates of
return. With apparently still high hurdle rates on fixed
investment, U.S. firms would have diverted more earnings than
before to dividends, share buy-back, mergers and acquisitions
relative to fixed investment, at least partly for the purpose of
boosting the price of their equity in the short term. Real fixed
nonresidential investment saw its contribution to real GDP growth
reduced by 0.4 percentage points per year in 2011-2015 relative to
the combined years 1996-2000 and 2004-2007. Perceived uncertainty
about the future evolution of factors that condition growth
prospects and future rates of return is likely to continue to
weight on the pace of business non-residential investment in the
years to come. These factors include among others:

In an uncertain environment, investment is postponed.
Flexibility commands a premium so that firms tend to use more
labour rather than increase capital per worker when they need to
raise production. This tends to boost employment at the expense of
capital deepening7 and therefore reduces labour
productivity growth.8

Productivity Growth

The slow growth of U.S. labour productivity growth over
2011-2015 (0.6 percent per year for businesses) need to be put in
perspective: rates for the total economy average 2.7 percent over
1948-1970, 1.5 percent over 1970-1994 and 2.3 percent over
1994-2004.9 Thus the recent period shows exceptionally
depressed labour productivity growth in the U.S. by historical
standards.

Conventional growth accounting reveals that this very slow
growth in labour productivity is attributable mostly to a fall in
capital deepening and, to a lesser extent, a low rate of
multifactor productivity growth. Thus, a recovery in trend labour
productivity growth in the future will likely depend on a rebound
of both capital deepening (the investment rate) and multifactor
productivity growth.

As discussed earlier, a future rebound in the investment rate,
which itself would partly depend on a pick-up in the innovation
rate, is far from assured given pervasive uncertainty ahead. This
casts a cloud over prospects for a future recovery in labour
productivity growth.

Prospects for a rebound in trend multifactor productivity (MFP)
growth also are far from assured. At the outset, it must be
acknowledged that what has caused the deceleration of MFP growth is
not well understood by economic analysts. The presumption is that
at least two broad factors have been involved. First, the pace of
innovation, as it translates into higher labour and capital
productivity, would have slowed markedly as a result of several
factors, including a lower investment rate by businesses. In
particular, investment in ICT, software and R&D grew
significantly more slowly in 2011-2015 than in 1996-2007 (4.4
percent per year vs 6.4 percent per year in the U.S.) and these are
the components of investment that are most likely to boost
multifactor productivity growth. While nobody contests that
technological progress is rapid in many spheres (e.g.,
ICT, artificial intelligence, big data, robotics, genomics...),
there is intense debate as to whether this will have a broad enough
scope to lift measured aggregate productivity growth significantly.
Thus, both murky prospects for a lift in investment rate,
particularly with respect to ICT, software and R&D, and the
uncertain scope of current technological progress make the future
contribution of innovation to productivity growth hard to
project.

A second potential factor in the decline of productivity growth
would be a decline in the intensity of competition. The pace of
creation of new firms appears to have slowed markedly in a context
of accelerated market consolidation by large, dominant
firms.10 At the same time, low interest rates and debt
charges would have boosted the survival of inefficient firms. Given
that productivity growth tends to be rapid in new (small) firms and
comparatively slow in older (large) firms,11 the average
rate of productivity growth at the firm level would have declined
as a result of these two developments, thereby depressing aggregate
productivity growth.12 More importantly, a decline in
competitive pressures would have reduced incentives for efficiency
and innovation13 and rising protectionist pressure would
reduce these incentives even further.

Another factor at play in the decline of productivity growth has
been a shift of labour away from the high-measured-productivity
financial services industry in the wake of the financial crisis. In
the U.S., for example, the share of total employment accounted for
by financial services fell from 6.1 percent in 2006 to 5.7 percent
in 2015. Given that measured labour productivity is much higher in
financial services than in the economy as whole, the shrinkage of
the labour share of financial services contributed to depress
aggregate labour productivity growth in the U.S. Of course, the
relative importance of this factor would have varied from country
to country. At this point, it is not likely that the relative
shrinkage of labour in finance will significantly reverse in the
next several years and raise aggregate productivity growth.

While one cannot be precise about the future evolution of
productivity, our judgment is that a rebound in U.S. labour
productivity growth from 0.5 percent per year is possible, but in
all likelihood to not much more than one percent, considerably
lower in any case than during the 1996-2007 period (Chart
1.9).

Transition in China

Further slowdown in the growth of China's final demand,
further shift in the composition of that demand away from
high-import-intensive investment toward consumption and services,
and further production at home of some previously imported
intermediate goods (onshoring) are to be expected in the years
ahead as the economy continues to transition toward a more
sustainable growth model and move up the value-added chain. This
will have modest negative spillover effects on growth in the
advanced economies through trade and in a number of
commodity-producing countries through weaker trade and commodity
prices. IMF research suggests that China's global spillovers
would add another 25 percent to the direct effects of a Chinese
slowdown in final demand growth on world growth (given growing
China's weight in world output, now at 17
percent).14 Thus, a slowing of 2 percentage points in
China would subtract 0.3 points from global growth directly and a
further 0.1 points indirectly. The spillover effect would be much
larger for some countries.

There is considerable uncertainty about the pace of the expected
slowdown in China over the next several years. One downside risk in
the short term arises from debt overhangs, property bubbles, and
unhealthy state-owned enterprises. Chinese growth has proven to be
surprisingly resilient recently, no doubt in response to a major
easing of economic policy (fiscal, monetary and the exchange rate).
This creates an upside risk to future growth relative to our
expectations inasmuch as the Chinese government has the willingness
and firepower to keep growth close to its planning targets over the
next few years. As will be seen in Section III, our own projection
calls for a fall in growth of 1.4 percentage points over the next
two years, a significantly more pessimistic outlook than most
others over this short horizon. This is because we think Chinese
authorities will have to sacrifice more growth than they are ready
to admit in order to accommodate other pressing policy goals, to
facilitate transition to a service economy and to avoid
exacerbating already large imbalances and financial risks in the
economy.

Commodity Prices

The key point that we want to emphasize is that the supercycle
of 2004-2014 is dead and that real commodity prices, particularly
those of oil and industrial materials, will fluctuate around flat
or at best slightly rising trends over the next several years.
Demand for commodities will continue to grow, but at a more
moderate pace as Chinese goods production and construction slow and
global growth remains subdued. With respect to oil, a relatively
price-elastic supply from the U.S. shale oil industry will likely
contain the upward price pressure likely to emerge from the recent
collapse of oil investment in the rest of the world. With respect
to metals, substantial new production capacity in recent years will
stem upward price pressure for years to come.

The implication of nearly flat real commodity prices ahead is
that future growth in the terms of trade, real income and resources
investment in commodity-producing countries, which include many
emerging economies, will be limited, contributing to keep aggregate
demand growth in these countries considerably lower than in
2004-2014.

Trade Developments

This sub-section takes account of recent analysis done by the
OECD and the IMF on why the growth in world trade has stagnated. In
the light of that analysis it considers the potential impact of
recent political developments, notably the American election and
the Brexit vote in the U.K. We also take a brief look at where
Canada fits in this picture.

An OECD policy paper15 issued in September 2016
notes:

"A remarkable two decade period of rapid globalisation,
during which the trade intensity of global GDP increased rapidly,
came to an end with the financial crisis. Instead of world trade
growing at more than double the rate of global GDP, in the wake of
the crisis it has barely exceeded the growth rate of global GDP,
slowing sharply from an average of 6½ per cent per annum
over the two decades to 2008 to 3¼ per cent per annum over
2012-2015. During 2015 trade volume growth weakened further to
2½ per cent, and was again anaemic in the first half of
2016."

The OECD paper identifies both cyclical and structural reasons
for the downturn. The paper observes:

"Trade growth in the pre-crisis period was boosted by
world-wide liberalisation of trade policy, particularly through
multi-lateral agreements, NAFTA and deepening of the E.U. single
market during the 1990s. A further boost to trade came from the
growing importance of global value added chains (GVCs), whereby
production processes are fragmented across countries and so
increased trade, particularly in intermediate products. As trade
liberalisation measures slowed around 2000, world trade remained
supported by the ongoing expansion of GVCs and was given a further
boost by a growing contribution from the rapid emergence of China
into the world economy."

Structural changes since the global financial crisis impacting
negatively on the growth of trade include:

a slowdown in the growth of
GVCs,

the declining effect of earlier trade
liberalization which is now fully implemented, and

the growth in restrictive trade
measures taken since 2008.

While political will has helped keep protectionist forces in
check there has been a steady creep in protectionist actions which
is taking a toll. The WTO recently reported that "the share of
world imports covered by import-restrictive measures implemented
since October 2008 and still in place is 5% and the share of G20
imports covered is 6.5%."16

The IMF in its October 2016 World Economic Outlook also focuses
on "Global Trade: What's behind the
Slowdown?".17 The IMF concludes that,
"Empirical analysis suggests that, for the world as a whole,
up to three-fourths of the decline in real goods import growth
between 2003–07 and 2012–15 can be traced to weaker
economic activity, most notably subdued investment growth."
Slower growth in China as noted elsewhere in our fall outlook is
another factor weighing on the growth of world trade. However, like
the OECD paper, the IMF also sees the role of structural factors as
being important.

Both institutions believe that renewed trade liberalization
would make a positive contribution to increased productivity and
renewed growth in the global economy. This being said, over the
remainder of this decade the prospects for trade liberalization,
and for the international trading system more generally, look
bleak. Equally bleak are the prospects for competitive pressures
from expanding trade to stimulate growth in productivity, potential
output and aggregate demand in the world economy.

Potential Trade Impact of Recent Political Developments

The election of Donald Trump as President of the United States
and the aftermath of the Brexit vote in the U.K. create major
uncertainties about the future course of trade policy globally.
However, there are important differences.

In the U.K., the government of Prime Minister Theresa May has
made clear publicly that it wants open trade with all its partners,
but from a position outside the European Union. What is unclear is
how it will get there and what sort of deal it will be able to
strike with the E.U.

In the U.S., Donald Trump has taken a series of protectionist
positions during the election campaign. Exactly how the bombastic
rhetoric of the election trail will be translated into policy once
he is sworn in as the 45th President on January 20 remains to be
seen. What is clear already is that:

During the campaign, in his
"contract with the American voter", Donald Trump stated
that as the first of "seven actions to protect American
workers" he would "announce my intention to renegotiate
NAFTA or withdraw from the deal under Article 2205."

Also in the "contract", he
said he would "announce our withdrawal from the Trans-Pacific
Partnership". Then, on November 21, President-elect Trump
provided a video "update on the transition and our policy
plans for the first 100 days" in which he announced that on
day one he is "going to issue our notification of intent to
withdraw" from the TPP. "Instead," he continued,
"we will negotiate fair, bilateral trade deals that bring jobs
and industry back onto American shores". His video update was
silent on NAFTA.

The Transatlantic Trade and
Investment Partnership (TTIP) negotiations between the U.S. and the
E.U. have been effectively sidelined.

The fate of other negotiations, such
as the Trade in Services Agreement (TISA) negotiations in Geneva
and other WTO negotiations, have been thrown up in the air.

Mr. Trump has appointed Dan DiMicco,
the former CEO of Nucor, the largest steel producer in the U.S., as
the point person for trade on the transition team. DiMicco has
taken a tough anti-China stance and has made clear the goal of the
administration will be to eliminate the trade deficit and to
"balance" trade.

All of these factors mean that the actions of the new
administration are much more likely to be trade restricting rather
than trade liberalizing. If that is the case they will clearly have
a negative impact on global growth.

It is possible that the Republican led Congress, most of whose
members are pro trade, will have a restraining effect on the
President as he approaches the trade agenda, but he has a lot of
wind in his sails and a lot of tools in his pocket. Most business
interests in the U.S. will be pressing for open trade, including
agriculture interests in many "red" states.

Obviously this turn of events presents real challenges for
Canadian policy. As the largest trading partner of the U.S. we
are on the edge of a crisis and preparations for what lies ahead
should be a top Canadian government priority.

The government should be prepared to enter discussions with the
new administration on NAFTA. To prepare for the likelihood that
there will be negotiations to change NAFTA, the government should
be developing a list of how Canada thinks the agreement could be
improved. We may not like the proposals that come from the American
side of the table, so deploying our own wish list will be
tactically important. One proposal that is almost certain to arise
from the U.S. will be targeted at dismantling Canadian supply
management programs in the dairy and poultry sectors.

It will be important for Canadians to work with their many
allies in the U.S. with whom common interests are shared, among
others on such important issues to Canada as country of origin
labeling regulations for meat, softwood lumber and the Keystone-XL
pipeline.

The government should also exchange views bilaterally with the
Mexicans. Sharing intelligence and comparing notes will be useful.
Bilateral discussions would also help guard against efforts by the
U.S. to play us off against each other.

We recommend that the Canadian government set two overriding
priorities with respect to Asia. First, now that the TPP has been
upended, re-engage bilateral talks with Japan to conclude the
Comprehensive Economic Partnership Agreement negotiations to take
advantage of benefits that would otherwise have come to Canadian
business through participation in the TPP. Second, expedite the
agreed exploratory discussions for a possible Canada-China Free
Trade Agreement, recognizing not only that China is our second
largest trading partner but, even more importantly, that China will
play an increasingly large role in setting international trade
rules, especially if the U.S. withdraws. The leadership of the
world trading order, which passed across the Atlantic from the U.K.
to the U.S. after World War I, is now about to be passed across the
Pacific from the U.S. to China.

As the U.S. enters a more protectionist phase, Canada should
differentiate itself as being open and outward looking, thereby
promoting Canada as a hospitable site for investment.

Canada now has a major opportunity to strengthen its
relationships with the E.U. The CETA agreement between Canada and
the E.U. has finally been signed and prospects are good that it
will enter into force provisionally in 2017 after ratification by
the European Parliament and after the necessary implementing
legislation is passed at the federal and provincial levels in
Canada. Given the uncertainty surrounding the U.S.-E.U. TTIP
negotiations it seems likely that Canadians will enjoy preferential
access to the E.U. for some time before their American competitors
catch up. This could offer Canadian business a major opportunity to
consolidate the benefits from the CETA. It will also increase the
attractiveness of Canada as an investment location for companies
interested in serving both the North American and European
markets.

It is clear that not every word uttered by Donald Trump during
the election campaign was carefully calibrated. Canadians will need
to watch closely as the administration develops its approach to
various trade issues. This transition will be more complicated than
most and it may be summer at least before some important points are
clarified. During this period the best approach for the Canadian
government is to keep a low profile while quietly preparing for
various scenarios.

It is also likely that even this administration over time will
begin to realize that it will be easier to manage American
interests in a world with trade agreements than in one without.

It is even possible that we may see an interest in the prospect
of new approaches in the WTO. It may begin with fireworks as the
U.S. takes on China but that might set the stage for a new effort
at rule-making designed to take account of the way the world now is
rather than how it was in 1986 when the last successful
multilateral round of negotiations was launched. Such a process
might also be given a push by the U.K. as it seeks to assert itself
as a fully independent member of the WTO. Canadians should be
giving thought to how to use such a development to advance our own
interests. We should be open to all possibilities for reviving
"the virtuous cycle of trade and growth".

Apart from demographics, the medium term evolution of key
elements of the new normal for advanced economies, including
uncertainty itself, remains far from clear but nonetheless could
well lead to persistent low growth. In the short term at least,
there appears to be agreement that growth in advanced economies
will remain subdued generally—a continuation of the "new
normal".

Section III: Global Growth Outlook 2016 – 2018

Against the background of the preceding analysis, we project a
"low for long" scenario with the global economy growing
on average at about three percent per year from 2016 to 2018, as in
the Spring 2016 Outlook (Table 3.1). While recovering in part from
a marked softening in 2016, growth in advanced economies remain on
the low-growth path of the "new normal" in 2017 and 2018.
Growth for emerging economies, on the other hand, strengthens
slightly in 2016 before gradually losing ground in the next two
years. This is the result of a cyclical recovery from the slowdown
of 2014-15 in many emerging economies, which gets blunted in 2017
and 2018 by the direct and indirect effects of a pronounced slowing
of growth in China.

Table 3.1:

Short-term Prospects for Output Growth (%)*

Share (%)

2015

2016

2017

2018

Canada

1.5

1.1

1.2 (1.4)

2.0 (2.4)

2.0 (1.9)

United States

16.4

2.6

1.5 (1.9)

2.3 (2.3)

2.3 (2.1)

Euro area

12.3

2

1.5 (1.6)

1.5 (1.6)

1.5 (1.5)

Japan

4.6

0.5

0.6 (0.8)

0.6 (0.7)

0.5 (0.6)

China

17

6.9

6.6 (6.1)

5.7 (5.2)

5.2 (4.8)

Rest of World

48.2

2.7

2.9 (2.9)

3.2 (3.2)

3.2 (3.2)

World

100

3.2

3.0 (3.0)

3.1 (3.1)

3.0 (2.9)

*Figures in brackets are from the Bennett Jones Spring 2016
Economic Outlook.

This scenario incorporates no major
specific shock from political or trade developments. This is a big
assumption in view of the current multiple risks, arising notably
from the results of the U.S. election. Most likely, however, the
environment will be less trade friendly.

Interest rates are expected to remain
low, with only a gradual rise in 2017; U.S. rates would rise
further in 2018 if U.S. fiscal policy becomes as expansionary as
Mr. Trump has promised. In any event, the total rise in U.S. policy
rate should be limited by historical standards, reflecting a much
lower neutral interest rate than in the past.18

WTI oil prices are expected to trend
upwards until they reach about US$60 in 2018. They are likely to
show volatility around this trend.

U.S. growth finally picked up well beyond its
potential rate in the third quarter of 2016 (2.9 percent) as
inventory investment and net exports rebounded after several
quarters of negative or very weak contributions to growth. Growth
should average only 1.5 percent for 2016 as a whole, but rise to
over 2 percent over the next two years.

The extent to which U.S. growth over the next two years exceeds
its medium term potential (estimated at 1.8-1.9 percent) depends in
part on the magnitude of Mr. Trump's promised tax cuts and
spending on infrastructure. At this point our best guess is that
these fiscal actions would start in the second half of 2017 and
might cumulate over time to more than one percent of GDP. Should
this be the case, this stimulus would raise real GDP growth by 0.1
to 0.2 percentage points in 2017 and 0.3 to 0.5 points in 2018 so
that GDP growth over those two years should average about 2.3
percent. Growth in business non-residential investment should pick
up in response to stronger aggregate demand growth and an economy
at capacity while net export gains are likely to be restrained by
additional upward pressure on the exchange rate of the U.S. dollar
and stronger domestic demand.

With an economy roughly at capacity to start with, the projected
above-potential GDP growth rate would be expected to generate some
inflationary pressure and the Federal Reserve would be expected to
react by raising its policy interest rate in both 2017 and 2018. By
the end of 2018, the policy interest rate would likely have risen
to close to 2.5 percent in nominal terms. The rise in U.S. rates
would likely widen the interest rate differentials in favour of
U.S. dollar assets and put upward pressure on the U.S. dollar.

The rebalancing of economic policies in the U.S. would have
spillover effects on the rest of the world, including Canada,
through trade and financial linkages. Section IV discusses the
advantages of a rebalancing of economic policies for advanced
economies.

In Canada growth in 2016 is turning out to be
very weak for a second year in a row as a result of low U.S. growth
in the first half of the year, continued difficult adjustment to
the earlier fall in commodity prices and collateral decline in real
income, tough competition in export markets, further retrenchment
in inventory investment, and wildfires in the Fort McMurray area in
the second quarter.19

Looking ahead, growth is expected to pick up from slightly above
one percent in 2016 to close to two percent in 2017 and 2018. In
view of the current considerable slack in the economy, this
somewhat faster-than-potential pace would not put pressure on core
inflation beyond the two-percent target over the next two years and
therefore would leave little room for policy rate increases. The
resultant widening interest-rate differential in favour of the U.S.
would exert downward pressure on the Canadian dollar, offsetting an
upward pressure on the currency arising from the projected increase
in international oil prices. The exchange rate could thus fluctuate
considerably during certain periods as expectations adjust to new
information. For planning purposes, we expect the Canadian dollar
exchange rate to move within a range of 71-77 U.S. cents over the
projection period.

As in the spring, we believe that several factors would support
stronger Canadian growth in the next two years. Total business
non-residential investment, which has been depressed by the
retrenchment in the oil and gas sector in the last two years,
should resume growth in 2017 as the economic expansion gathers
momentum and investment in the oil and gas sector stabilizes or
edges up. Likewise the drag on final domestic demand exerted by the
loss of real income associated with the earlier fall in the prices
of oil and other commodities should diminish, thereby boosting
growth relative to 2016. Firmer growth in the U.S., including in
import-intensive U.S. investment in machinery and equipment, should
also support a faster Canadian expansion via stronger export
demand. Finally, stimulative fiscal measures by the federal
government, mainly in the form of increased infrastructure
investment and larger transfers to households (Canada Child
Benefit), would boost growth in 2017 relative to 2016. These
measures would continue to support the level of activity in 2018
but are unlikely to make a significant additional contribution to
growth in that year.

For Canada the risks revolve around:

the impact of President Trump
policies on U.S. demand and interest rates;

the evolution of oil prices;

the impact of the federal fiscal
stimulus; and

the competitiveness of Canadian firms
in export markets, notably the U.S.

An additional risk regarding Canadian exports relates to the
potential restraining effects of U.S. protectionist measures put in
place by Mr. Trump's government.

To conclude, at this juncture we expect for the short term much
the same scenario of subdued global expansion and strengthening
growth in the U.S. and Canada as in the Spring 2016 Outlook. With a
Trump administration in place, a rebalancing of economic policies
in the U.S., which would have taken place at least in small measure
anyway, will likely be reinforced to some degree insofar as an
expansionary fiscal policy boost growth and inflation in the U.S.
in the short term. This fiscal stimulus would have positive
spillovers on the rest of the world, including Canada, in the short
term. At the same time a more protectionist trade policy by the
U.S. would certainly have negative effects on the rest of the
world. While the U.S. fiscal stimulus and its positive spillovers
would be over by 2018, the drag on global growth arising from the
U.S. protectionist measures would continue and possibly get
worse.

SECTION IV: IMPLICATIONS FOR GOVERNMENT POLICIES AND BUSINESS
STRATEGY

Implications for Economic Policies

Rebalancing economic policy with less reliance on monetary
policy and more reliance on public investment and structural
policies would help to achieve stronger demand growth in advanced
economies and hence help break out of the "new normal".
At the September 2016 G20 meeting, many government leaders
expressed interest in such rebalancing. While the economic plan of
the Trump administration in the U.S. implies a vigorous
rebalancing, any rebalancing on the coordinated international basis
that would be necessary to materially boost global growth remains
problematic.

Monetary Policy

Central banks contribute to the stabilization of real domestic
demand through the setting of their policy interest rate.
Traditionally, a cut in interest rates worked to induce increased
demand in the near term because businesses and consumers viewed
that over time inflation would increase—hence there was an
advantage to bringing forward intended expenditure and take
advantage of lower borrowing costs. The reduction in rates would
also have an impact on the exchange rate, inducing demand for
domestic output. Since the onset of the financial crisis, a slide
in policy interest rates to near zero supplemented by a heavy dose
of unconventional monetary policy in a number of advanced countries
provided support to aggregate demand and boosted asset prices.

The efficacy of monetary policy to stimulate demand appears to
be lower now than it used to be. First, the limited success of the
extraordinary efforts of central banks to lift aggregate demand
growth beyond mediocre rates after 2010 have led to expectations
that interest rates will be "low for long" and to a
flattening of the yield curve, thereby providing less incentive to
pull forward more consumption and investment. Second, with
household debt/disposable income ratio at an all-time high in
Canada, and approaching that again in the U.S. and many other
economies (including EMs), households are reluctant to incur more
debt even though the ratio of current debt service costs
to disposable income is low, indeed at an all-time low in Canada
(6.4 percent vs 11 percent in 1990).20 Third,
"radical uncertainty", to use a Mervyn King
term,21 prevails and induces caution on the part of
households and businesses. Finally, the efficacy of monetary policy
is limited by the effective lower bound on nominal interest rates.
The greatest danger at present is that there is no room to lower
rates by the 400+ basis points needed to pull an economy out of
recession before hitting the effective lower bound, should there be
another dramatic collapse in demand.

Not only is there almost no practical room to use monetary
policy going forward to stabilize growth in the event of a major
negative demand shock, there is accumulating anecdotal
evidence and increasing concern that today's ultra-low rates
may actually be retarding growth (by inducing a rise in retirement
saving), widening income inequality and distorting financial
markets (causing uncertainty and leading to a misallocation of real
resources).

Fiscal Policy

In the end it is not going to be modifications to monetary
policy alone that offer the greatest chance for macro-economic
policy to facilitate the escape from the current global economic
stagnation. Fiscal policy has an important role to play as indeed
it did in the past, not only in the severe slump of 2008-2009 but
also as part of the activist Keynesian approach to stabilize the
economy that prevailed in the first few decades of the post-war
period. Recent statements from the IMF and the communiqué
from the G20 meeting in Hangzhou indicate that many authorities now
acknowledge the importance of expansionary budgets as a source of
aggregate demand growth. Clearly this was recognized by the
Canadian federal government in setting its 2016 Budget. But it is
not just change in the size of the deficit that matters for growth;
change in the composition of spending and revenues is even more
important in the medium term. Thus, increasing public investment in
productivity-enhancing infrastructure raises the long term growth
trajectory—and hence expected real growth over the longer
term.22

Globally many governments have the capacity to increase their
borrowing at current interest rates provided that borrowing is used
to finance productivity-enhancing physical or human
infrastructure—infrastructure which will yield future cash
flows to governments. The Canadian government has seized this
opportunity in the spring 2016 Budget by committing in a first
phase to invest $14 billion in infrastructure between 2016 and
2020. In a fall economic statement on November 1, the federal
government committed to deliver an additional $81 billion between
2017 and 2027 to fund public infrastructure, this time partly
through the agency of a newly established Canadian Infrastructure
Bank and with a focus both on attracting private sector investment
and relying at least in part on user charges to fund the
operational, maintenance and financing costs of new
infrastructures.23 Clearly all these infrastructure
initiatives have the potential, if well executed, not only to
stimulate demand in the economy over the next several years, but,
more importantly still, to enhance trend productivity growth and
hence potential output growth over the longer term.

Policy Mix

While demographic, technological, and structural factors clearly
limit the extent to which macro-economic policies alone can promote
higher growth, judicious coordination of monetary and fiscal
policies can get countries closer to that limit than can disparate
efforts of central banks and finance ministries in their respective
domains. At the present time, both price and financial stability
would be better served by somewhat higher policy interest
rates—rates that would not imply a sacrifice of employment
and growth if (and this is a big if) fiscal policy were more
expansionary.

Macro-economic policies alone, however, will not materially lift
long-term growth rates. If the advanced economies of Europe and
North America are to achieve growth rates closer to those
experienced in the second half of the last century, it is essential
that governments focus on growth-enhancing structural
policies—trade, education, health, competition, income
distribution, taxation and public infrastructure investment.
Competition and open international trade provide incentives for the
development of new technology. But it is labour, education and
income distribution policies that provide reasonable assurance that
gains from trade and technological progress will be reasonably
shared. Without such assurance, popular resistance to change can
grind economic growth to a halt.

To conclude, a rebalancing of economic policy to place greater
emphasis on government investment and structural policies and
somewhat less reliance by central banks on ultra-low interest rates
and long-term asset purchases (QE) would be a step towards escaping
from the current stagnation of global economic growth, enhancing
competition and productivity-raising investment, improving the
distribution of income and wealth, and supporting the losers from
technological change and globalization. Although such rebalancing
is more likely than not, its implementation remains uncertain both
in timing and extent. One important issue with increased reliance
on fiscal policy is that it is hard to know when enough is enough
and hard politically to turn the wheel in a timely fashion when and
if fiscal restraint is ultimately required.

Implications for Business Strategy

In this world of slow growth and heightened uncertainty,
businesses need to put an emphasis on flexibility, adaptation and
technological innovation while at the same time maintaining a
reserve of dry powder to meet unforeseen circumstances. Continued
reinvestment of profits at a somewhat lower hurdle rate than was
used a decade ago will be essential to maintaining productivity and
competitive advantage over time.

Until well into 2017 there will be a good deal of political and
economic uncertainty related to the Trump administration actions,
Brexit, the December vote in Italy, and national elections in
France and Germany. During this period, it would be wise for
businesses to make plans for the future but refrain from making
commitments until these uncertainties are substantially lifted.

1 Gains in international trade intensity are measured by the
differences between growth in world real GDP and growth in world
trade volumes of goods and services. For more details on the causes
of the decline in trade intensity, see the sub-section on trade
developments in Section II.

2 The fall in import growth exaggerates the amount of negative
spillovers on the rest of the world. Some of the slower import
growth reflects negative shocks originating outside China. See IMF.
2016. "Spillovers from China's Transition and from
Migration", World Economic Outlook, October.

3 Commodity supercycle here refers to "the rise, and fall,
of many physical commodity prices (such as those of food stuffs,
oil, metals...) which occurred during the first two decades of the
2000s (2000–2014), following the Great Commodities Depression
of the 1980s and 1990s. The boom was largely due to the rising
demand from emerging markets..., particularly China..., as well as
the result of concerns over long-term supply availability...The
2000s commodities boom is comparable to the commodity supercycles
which accompanied post–World War II economic expansion and
the Second Industrial Revolution in the second half of the 19th
century and early 20th century." Wikipedia, 2000s
Commodity Boom entry.

4 The distribution of saving rate by age groups would have a
hump shape with a peak at age group 55-59.

5 The weak static effect stems from slow increases in the
population shares of older age groups (65+) and decline in the
share of the young age group (0-24) whose saving rate is
practically nil.

6 Intra-country income inequality has been going up mainly
because income has been rising rapidly at the very high end
relative to the middle income earners. Inter-country inequality has
been going down because of huge increases in income overall in
countries like China, India, Indonesia, etc. The overall
effect has been an increase in a global class of super rich
combined with a global decrease in poverty and a strong growth of a
middle class (in emerging economies). See Milanovic, B. 2016.
Global Inequality: A New Approach for the Age of
Globalization, Harvard University Press.

7 Capital deepening refers to an increase in capital input per
labour input. With a slower growth in labour input, the same
capital deepening would be achieved with a slower growth in capital
input, hence lower investment. Besides uncertainty, demographics
could lead to a lower investment rate than otherwise as the
projected slower growth in hours worked would require a lower
investment rate to accommodate the same pace of capital deepening
as before. If the lower supply of hours leads to upward pressure on
wages, however, desired capital deepening may actually rise faster
than before and this would help support the investment rate.

8 The potential conflict between capital deepening and job
creation seems part of the political dynamic trade-off that appears
to be taking place.

9 Gordon, R. 2016. The Rise and Fall of American
Growth. Princeton University Press, Table 18.3.

10See "The rise of the superstars", The
Economist, September 17-23, 2016, and Council of Economic
Advisers. 2016. "Benefits of Competition and Indicators of
Market Power", Council of Economic Advisers Brief,
April.

12 However, small firms tend to have a lower productivity level
than large ones. A rise in the proportion of large firms would thus
raise the average level of aggregate productivity as a
result. The net effect on aggregate productivity growth of slower
average growth of productivity at the firm level and rising
aggregate level of productivity as concentration increases is an
empirical issue.

13 This argument must not be pushed too far. Empirical support
was found for the prediction that the threat of firm entry spurs
innovation in sectors close to the technological frontier whereas
it discourages innovation in laggard sectors because it reduces the
incumbents' expected rents from innovating. See Aghion, P., R.
Blundell, R. Griffith, P. Howitt and S. Prantl. 2006. "The
Effects of Entry on Incumbent Innovation and Productivity".
NBER Working Paper No. 12027.

14 IMF (2016), p. 174.

15 "Cardiac Arrest or Dizzy Spell: Why is World Trade so
Weak and What Can Policy Do About It?", OECD Economic Policy
Paper. September 2016 No. 18.

18 The neutral interest rate is the policy rate consistent with
the economy operating at capacity and inflation remaining on
target. Given a lower neutral rate at present, actual policy rates
need not rise as high as before to eliminate excess demand in the
economy.

19 Oil sands production returned to normal by the third quarter
so that the temporary wildfire-related fall in oil sands production
would have had only a small effect on Canadian GDP growth for 2016
as a whole.

20 Statistics Canada Cansim 380-0073.

21 King, M. 2016. The End of Alchemy: Money, Banking and the
Future of the Global Economy. Norton.

22 Public infrastructure covers a wide range of assets. Some
would enhance population welfare but have dubious value when it
comes to long-run enhancement of productivity. Thus the mix of
infrastructure investment, and not just the amount, matters for
long-term growth.

A short while ago, a client called to share the details of a procurement process gone wrong. The facts were unusually ghastly. The client, a just-declared unsuccessful bidder, had spent a princely sum of money – not to mention considerable time and effort – preparing and submitting a proposal, the kind that was supposed to knock the competition out of the box.

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